Why are seemingly so many on this forum (and elsewhere) often so keen on not paying down a mortgage balance, but at the same time willing to buy BND at its current "low" yield level?

I get that in a practical sense you lose liquidity paying down a mortgage and having some BND allocation is useful for re-balancing. But once one has a healthy amount of bonds/cash/ongoing cash flow with which to re-balance with, wouldn't it make sense to be paying down a 4% mortgage right now instead of buying more 2.5% yielding bonds? Net of the tax break I still see the mortgage yielding more (assuming BND is in a tax sheltered account), and you are taking mark to market risk with BND which you aren't with a mortgage. If you are 100% equities then surely this doesn't apply, but for most people I think it doesn't make sense to lever up at a cost of 4% (minus tax break) to buy something yielding 2.5%. What am I missing? Are people just brain washed by the mortgage/banking/housing industry and buying into the whole "oohhh, i get a tax break" nonsense?

One reason is that while 4% is a high rate now, the mortgage is for a long time, maybe 30 years. If rates return to historical levels, you can have a 4% mortgage while bonds/CDs etc. yield 5% or 6%. If that happens, you would be glad to have that "low" rate mortgage. When I bought my first house in 1971, I had a 6.75% mortgage. Less than ten year later, I was earning 18% in my money market fund. I was very happy to paying "only" 6.75%.

If your overall portfolio is expected to return less than a tax adjusted 4% then yes, it would make sense to pay down your mortgage.

Ah ha! I think that's exactly it. You nailed it and that's why I love this site. Maybe then my real issue is that I am not feeling confident (or even neutral) about forward returns being very good in the short to medium run? Yes, market timing, I know. I'm too pessimistic.

In this case I guess you could say paying down a mortgage is like adding to one's bond allocation but at a more attractive rate?

sport wrote:One reason is that while 4% is a high rate now, the mortgage is for a long time, maybe 30 years. If rates return to historical levels, you can have a 4% mortgage while bonds/CDs etc. yield 5% or 6%. If that happens, you would be glad to have that "low" rate mortgage. When I bought my first house in 1971, I had a 6.75% mortgage. Less than ten year later, I was earning 18% in my money market fund. I was very happy to paying "only" 6.75%.

Ok yes, but people keep seeming to forget that in this situation, you would be feeling pretty sore with your BND losses. So unless you are just using cash/CDs for your bond allocation, you will be getting hurt if rates rise by a large margin and with any kind of speed.

sport wrote:One reason is that while 4% is a high rate now, the mortgage is for a long time, maybe 30 years. If rates return to historical levels, you can have a 4% mortgage while bonds/CDs etc. yield 5% or 6%. If that happens, you would be glad to have that "low" rate mortgage. When I bought my first house in 1971, I had a 6.75% mortgage. Less than ten year later, I was earning 18% in my money market fund. I was very happy to paying "only" 6.75%.

Ok yes, but people keep seeming to forget that in this situation, you would be feeling pretty sore with your BND losses. So unless you are just using cash/CDs for your bond allocation, you will be getting hurt if rates rise by a large margin and with any kind of speed.

Of course. This is why you keep your bond durations within bounds. As with most things, it's all about balance and moderation.

If your overall portfolio is expected to return less than a tax adjusted 4% then yes, it would make sense to pay down your mortgage.

These are not equivalent investments. Paying on a mortgage is a guaranteed return on investment. Your portfolio is not risk free like this.

If you choose your portfolio over your mortgage you are taking on more risk. Some people are fine with that, but they are not the same investment.

Carrying a mortgage is leverage, so it increases risk. That being said it is the mildest type of leverage out there. Your mortgage has a duration of about 15, assuming it is brand new. BND has a duration of about 7. If either real intrest rates increase or inflation increases one would be better off not paying down your mortgage and investing elsewhere.

However, lets look at flexibility. It is easy to pay down your mortgage, it is not easy to increase it. All of my fixed income is in my tax advantaged accounts. Should I pull out my fund and pay a penalty? Should I skip my company's match? No. Flexibility has value.

WarChest wrote:Why are seemingly so many on this forum (and elsewhere) often so keen on not paying down a mortgage balance, but at the same time willing to buy BND at its current "low" yield level?

I get that in a practical sense you lose liquidity paying down a mortgage and having some BND allocation is useful for re-balancing. But once one has a healthy amount of bonds/cash/ongoing cash flow with which to re-balance with, wouldn't it make sense to be paying down a 4% mortgage right now instead of buying more 2.5% yielding bonds? Net of the tax break I still see the mortgage yielding more (assuming BND is in a tax sheltered account),

Contrary to what a lot of people advocate, the net of the tax break doesn't really make any difference in your net return for paying down a mortgage. That's because money is fungible. Once it's in your pot of after-tax money, it doesn't matter where it came from, and it doesn't matter which debt you pay off. The net result in increasing your net worth for paying down a mortgage or any other debt is the nominal rate of the debt plus the taxes you don't pay on the gain in net worth. (Whereas you do pay tax on the dividends and capital gain for the same money in a taxable account.)

A big problem is that paying down the mortgage is somewhat like buying a bond or CD that you cannot easily cash out before it matures. So IMO you need to have a lot of liquid assets before you pay extra on the mortgage. IMO, you should be maxing all available tax advantaged retirement accounts, have at least 6 months to a year of living expenses in liquid assets (including any Roth IRAs) and have most other debts paid off except perhaps student loans before you pay any extra on a mortgage.

Also bear in mind that once you have paid off a mortgage ahead of schedule, you own the equivalent of a bond fund or annuity that guarantees the monthly payment at the mortgage rate for the remaining life of the original mortgage.

Plus, when your mortgage is paid off, you can reinvest the freed up payments, and you're not diminishing your return by the interest you would have been paying the lender for the money if you still had a mortgage.

Even better, if the market crashes or you have a financial setback you can hold off on investing your freed-up payments for a while. Vanguard or Fidelity cannot foreclose on your house if you stop investing for a while, but your mortgage lender will if you stop making payments, no matter how good your reason.

One other thing that's somewhat less important is that like your 401(k) funds, the equity in your home is typically a lot better protected from creditors in case of a lawsuit and judgment against you, where they might be able to seize your assets in taxable accounts and savings.

Are people just brain washed by the mortgage/banking/housing industry and buying into the whole "oohhh, i get a tax break" nonsense?

I think so. In fact the IRS says that only about one in four taxpayers exceeds the standard deduction and gets any tax break for their mortgage interest. Then the majority of ones who can itemize only save pennies on the dollar, and still pay a lot of money out in after-tax mortgage interest.

Ironically, there have been polls that have shown that about 2/3 to 3/4 of taxpayers are opposed to eliminating the mortgage interest deduction, even though only 1/4 of them get any benefit from it at all. That's proof of how powerful the hype is from the mortgage/banking/housing industry.

If your overall portfolio is expected to return less than a tax adjusted 4% then yes, it would make sense to pay down your mortgage.

Ah ha! I think that's exactly it. You nailed it and that's why I love this site. Maybe then my real issue is that I am not feeling confident (or even neutral) about forward returns being very good in the short to medium run? Yes, market timing, I know. I'm too pessimistic.

In this case I guess you could say paying down a mortgage is like adding to one's bond allocation but at a more attractive rate?

Although I have a 4% mortgage, my actual rate is lower due to itemized tax deductions. I anticipate my overall portfolio will out perform this rate (as stated above).

I think you are under-estimating the value of liquidity. The money that could go to my mortgage goes into my taxable account. If the economy tanks and I lose my job, I can sell assets. You can't eat your paid off mortgage (and a HELOC may not be available in this setting).

If your overall portfolio is expected to return less than a tax adjusted 4% then yes, it would make sense to pay down your mortgage.

Ah ha! I think that's exactly it. You nailed it and that's why I love this site. Maybe then my real issue is that I am not feeling confident (or even neutral) about forward returns being very good in the short to medium run? Yes, market timing, I know. I'm too pessimistic.

In this case I guess you could say paying down a mortgage is like adding to one's bond allocation but at a more attractive rate?

Although I have a 4% mortgage, my actual rate is lower due to itemized tax deductions. I anticipate my overall portfolio will out perform this rate (as stated above).

Yes, your actual rate for the mortgage may be lower than the mortgage rate. But paying extra on the mortgage still increases your net worth at the mortgage rate plus the taxes you don't pay on the gain -- when it's compared to investing the same money in a taxable account.

You may earn more in your portfolio, or you may not. But the net result for paying down a debt is guaranteed by the laws of math. Not hoping that you can do better.

I think you are under-estimating the value of liquidity. The money that could go to my mortgage goes into my taxable account.

Liquidity is important. As I state above, I think you should be maxing all available tax-advantage retirement accounts and have 6 months to a year of living expenses before you pay any extra on the mortgage.

However, once it IS appropriate to pay down the mortgage -- if you prefer the guaranteed mortgage rate+tax rather than gambling with your house in the pot that you might be able to earn more in the market -- then you'll come out better by paying as much as you plan as soon as you can on the mortgage instead of waiting to pay it down later. That's because mortgages work exactly like compound interest, but "in reverse". Time is an exponential factor, and interest is calculated on the unpaid balance at 1/12 of the yearly rate every month. Because of that, you can earn more in an investment by starting sooner. And you can avoid paying more interest by paying down the debt as soon as you can.

If the economy tanks and I lose my job, I can sell assets.

Not if your assets were in aggressive stock mutual funds that have tanked too.

You can't eat your paid off mortgage (and a HELOC may not be available in this setting).

True.

But if you have a big enough emergency fund -- like you should before you pay down a mortgage -- then you can make the payment for a long time while you look for a job. If you have no mortgage payment, you can live a long time on an emergency fund and lower pay when you only have to pay the taxes and insurance.

Or if you suffer a setback like a lower paying job before the loan is completely paid off, you're a lot more likely to qualify to refinance for a lower and more affordable payment for a longer time if you've reduced the mortgage balance by a big chunk before the economy and/or your job tank.

Owing a lot less on the house might also make it easier to sell if the housing market has tanked, without having to come up with cash to pay off an upside down mortgage, in case you need to move to find another job.

Well, the after tax cost of the mortgage depends on your tax rate. The.same loan could be better or worse than a bond investment for those with differing margunal rates.

Right now, those who bought or refinanced a year a go are closer to 2.75%. After tax there are muni bond funds that beat that. Again, depending on your tax rate.

Note that the simpler comparison is to a muni fund, where you don't pay federal tax at all. The comparison of after tax mortgage to taxable bond held in a tax favored account only works for a Roth. If held in a regular IRA, 401(k) or 493(b), that money will be taxed when it comes out. The real effective return must be reduced to take that into account.

We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either |
--Swedroe |
We assume that markets are efficient, that prices are right |
--Fama

Bogleheads that advocate paying off their mortgage are almost always completely debt free. We emphasize the risk free return of prepaying a mortgage and the psychological benefits of being completely debt free.

Bogleheads that advocate not paying off the mortgage usually have one. They emphasize that their risk adjusted returns will be better than prepaying a mortgage.

Neither camp is wrong. It's a personal finance issue rather than an arithmetic issue because either choice involves risk and highly individualized personal circumstances.

I also would like to add that I hope when everyone figures out what their tax savings are from carrying a mortgage they are subtracting out the loss of standard deduction.

For example, if you are a married couple in the 25% tax bracket and have $10,000 in mortgage interest, $5000 in property taxes, and $3000 of "other" deductible expenses, you are only saving $1350 in federal income tax over the standard deduction as you're only capturing a benefit on $5400 of that mortgage interest. On a $250k 30 year loan at 4% that makes your year 1 interest rate equivalent to 3.5%. Not that big of a savings considering every year that number will go down.

WarChest wrote:Why are seemingly so many on this forum (and elsewhere) often so keen on not paying down a mortgage balance, but at the same time willing to buy BND at its current "low" yield level?

I get that in a practical sense you lose liquidity paying down a mortgage and having some BND allocation is useful for re-balancing. But once one has a healthy amount of bonds/cash/ongoing cash flow with which to re-balance with, wouldn't it make sense to be paying down a 4% mortgage right now instead of buying more 2.5% yielding bonds? Net of the tax break I still see the mortgage yielding more (assuming BND is in a tax sheltered account), and you are taking mark to market risk with BND which you aren't with a mortgage. If you are 100% equities then surely this doesn't apply, but for most people I think it doesn't make sense to lever up at a cost of 4% (minus tax break) to buy something yielding 2.5%. What am I missing? Are people just brain washed by the mortgage/banking/housing industry and buying into the whole "oohhh, i get a tax break" nonsense?

He basically says if you have a mixed portfolio of stocks and bonds, it makes sense to take money out of bonds and pay off your mortgage. That's exactly what I did. I didn't need the mortgage for liquidity (total portfolio was 5-6x the mortgage) and the mortgage was 4.6% while my bonds were paying less. I hated seeing both the bonds and the mortgage on my balance sheet with the difference in their rates. Now I have a higher stock allocation and no debt.

LRDave wrote:My young cohorts think I am making it up when I recall the early 80's. When young, a low interest-rate mortgage is such a blessing (IMO)....

Been there.

In the early and mid 80's my company (AT&T) was having trouble getting people to accept promotions to move from Atlanta regional headquarters and other areas where housing was relatively cheap to their national headquarters in New Jersey because of the higher cost of housing in the NorthEast and because of the high costs of mortgages ... which were in the neighborhood of 16-17% at the time. (At that time, my entire paycheck after a promotion would not been able to buy and pay for a home in central NJ that was comparable to the one we had in the Atlanta area.)

One incentive they offered to cut down on the risk on mortgages was to offer a guarantee for folks who relocated and bought new homes with ARMs (Adjustable Rate Mortgages) in order to have somewhat lower initial rates. The company would guarantee by contract that if the ARM mortgage rate went above 21%, they would pay the difference in interest until the rate came back down to no more than that amount.

Between 73 and '84 we paid off two mortgages in about 10 years each -- the first at a fairly good rate rate of 9.5% and the other at a steal of a deal loan assumption at only 10% ... which was several points below prevailing rates for new mortgages at that time.

With capital gains rates at 28%+ plus state tax our net results for paying down the mortgages were guaranteed in the range of 13-14%. The SP 500 had some wild ups and downs during that time and we felt it was way too risky. Of course back then there were some years when if we had been able to invest bigger lump sums we could have done better than 14% with CDs with no risk either.

Here are some gee-whiz figures gathered from a Freddie Mac site a while back.

To me, the decision to carry a mortgage is not tied to what bonds are paying. My after tax cost is 2.09% per year versus a Fed inflation target of 2%, and recent inflation has been in that neighborhood. This makes my mortgage basically free because I'll pay it back with inflated dollars. It is also a good hedge against rising rates and against inflation.

I also live in a depressed area and I have a house that is nice for the area. This means I'm getting killed on taxes to a high property tax rate. So paying off my mortgage would not provide piece of mind because I can't pay off my taxes. Liquidity does provide piece of mind.

Mid and long-term rates are currently anomalously low and I've adapted to that by getting a handle on my debt aversion. I've purposely accumulated low rate debt instead of trying to eliminate it. Back when I had to pay 6%, I made an effort to reduce my level of debt.

To get a fair comparison, you need to match durations. If you have 25 years left on your mortgage, then an extra mortgage payment is equivalent to buying a 25-year bond. 25-year zero-coupon Treasury bonds yield 3.00%, so you break even investing in a 25-year Treasury bond in your IRA rather than paying down the mortgage. 25-year bonds with risk comparable to Total Bond Market yield about 4%. And that makes investing in the IRA significantly better, since you will keep the tax-deferred growth in the IRA once the mortgage is gone.

Similar issues apply for a taxable investment. If you have a 3% mortgage with 7 years left, and are in a 25% tax bracket, the cost is 2.25% after tax. Admiral shares of Long-Term Tax-Exempt yield 2.48%; they have a bit of risk but more liquidity. The liquidity is useful because you retain the option of paying down the mortgage later, or not. If rates stay the same when the mortgage is down to 5 years, it will be worth paying down and you can sell your taxable investment to make the payment; if rates rise, you don't pay the mortgage down.

I guess we were lucky that I didn't have to drill down on the financial implications of keeping a mortgage or not ..... we just knew we wanted to own our homes free and clear so we paid off debt. We love the freedom of not having debt payment obligations.

If your overall portfolio is expected to return less than a tax adjusted 4% then yes, it would make sense to pay down your mortgage.

Ah ha! I think that's exactly it. You nailed it and that's why I love this site. Maybe then my real issue is that I am not feeling confident (or even neutral) about forward returns being very good in the short to medium run? Yes, market timing, I know. I'm too pessimistic.

In this case I guess you could say paying down a mortgage is like adding to one's bond allocation but at a more attractive rate?

WarChest,

The portfolio return does not have to be good in order to beat 4% mortgage rate. You have to be extremely pessimistic in order to believe that portfolio return is less than 3.X%.

Please note that BND yield is 2.5%. S&P 500 Index yield is around 2+% too. So, the portfolio only needs 1+% capital appreciation in order to beat 4% mortgage rate.

Whatever you do, please do not pay 25% tax in order to pay down your 4% mortgage. If you are in the 25% marginal tax rate and you choose not to contribute more to your Trad. 401K. But, you prepay your mortgage. This is essentially paying 25% tax in order to save 4% interest.

jimb_fromATL wrote:The net result in increasing your net worth for paying down a mortgage or any other debt is the nominal rate of the debt plus the taxes you don't pay on the gain in net worth. (Whereas you do pay tax on the dividends and capital gain for the same money in a taxable account.)

Paying down a mortgage makes exactly zero difference to your net worth - you are just moving money from one account to another when doing so.
The only thing it does is reduce the amount of future interest you will pay on that mortgage - to zero if you are paying the mortgage off in full.
For those of us who itemize every year and are in high tax brackets, paying down/paying off it will also increase the amount of income taxes due annually.

jimb_fromATL wrote:
Even better, if the market crashes or you have a financial setback you can hold off on investing your freed-up payments for a while. Vanguard or Fidelity cannot foreclose on your house if you stop investing for a while, but your mortgage lender will if you stop making payments, no matter how good your reason.

But the city or county will foreclose on you also if you fail to pay your property taxes. The annual amount of property taxes I pay is already higher than the amount of interest.

If you have the funds to pay down/off your mortgage, but choose not to do so, you can also keep those funds (ie. don't spend them) for a rainy days. You'll be much better off with liquidity even if you still have both a mortgage and property tax payment, than little to no liquidity, no mortgage, and still having to make a property tax payment (and of course, still having many other expenses).

One other thing that's somewhat less important is that like your 401(k) funds, the equity in your home is typically a lot better protected from creditors in case of a lawsuit and judgment against you, where they might be able to seize your assets in taxable accounts and savings.

Home equity is only protected from judgments up to a point - $75k in California - that would be the equivalent of a closet, maybe.
401k and IRAs are actually better protected than home equity.

I think so. In fact the IRS says that only about one in four taxpayers exceeds the standard deduction and gets any tax break for their mortgage interest. Then the majority of ones who can itemize only save pennies on the dollar, and still pay a lot of money out in after-tax mortgage interest.

And then again, there are the Bogleheads who know how to do math. I would wager far more than 1 in 4 bogleheads benefit from itemizing, and those that don't probably know so.

jimb_fromATL wrote:Even better, if the market crashes or you have a financial setback you can hold off on investing your freed-up payments for a while. Vanguard or Fidelity cannot foreclose on your house if you stop investing for a while, but your mortgage lender will if you stop making payments, no matter how good your reason.

But the city or county will foreclose on you also if you fail to pay your property taxes. The annual amount of property taxes I pay is already higher than the amount of interest.

If you have the funds to pay down/off your mortgage, but choose not to do so, you can also keep those funds (ie. don't spend them) for a rainy days. You'll be much better off with liquidity even if you still have both a mortgage and property tax payment, than little to no liquidity, no mortgage, and still having to make a property tax payment (and of course, still having many other expenses).

One way to look at this: You owe $100K on your mortgage, and $100K in cash, which you could use either to pay down the mortgage or to invest. If you have a financial setback, would you be better off with a $100K mortgage and $100K in investments, or with neither? If you invested the money, you can start withdrawing your investments; even if they are in an IRA, your financial setback means that you are in a low tax bracket and the cost for withdrawing them will be lower.

You could even view your mortgage as a negative bond, and invest the money that would have otherwise gone to the mortgage payoff in a bond portfolio with the same duration as the mortgage. This bond portfolio can make the mortgage payments without requiring any extra money from you.

I think so. In fact the IRS says that only about one in four taxpayers exceeds the standard deduction and gets any tax break for their mortgage interest. Then the majority of ones who can itemize only save pennies on the dollar, and still pay a lot of money out in after-tax mortgage interest.

And then again, there are the Bogleheads who know how to do math. I would wager far more than 1 in 4 bogleheads benefit from itemizing, and those that don't probably know so.

And those taxpayers who are considering paying down a mortgage versus investing the money are much more likely to itemize deductions. The fact that they can consider investing the money implies a higher salary, and thus likely high state taxes, more money to donate to charity, and a more expensive house with higher property taxes.

jimb_fromATL wrote:
Even better, if the market crashes or you have a financial setback you can hold off on investing your freed-up payments for a while. Vanguard or Fidelity cannot foreclose on your house if you stop investing for a while, but your mortgage lender will if you stop making payments, no matter how good your reason.

But the city or county will foreclose on you also if you fail to pay your property taxes. The annual amount of property taxes I pay is already higher than the amount of interest.

If you have the funds to pay down/off your mortgage, but choose not to do so, you can also keep those funds (ie. don't spend them) for a rainy days. You'll be much better off with liquidity even if you still have both a mortgage and property tax payment, than little to no liquidity, no mortgage, and still having to make a property tax payment (and of course, still having many other expenses).

One other thing that's somewhat less important is that like your 401(k) funds, the equity in your home is typically a lot better protected from creditors in case of a lawsuit and judgment against you, where they might be able to seize your assets in taxable accounts and savings.

Home equity is only protected from judgments up to a point - $75k in California - that would be the equivalent of a closet, maybe.
401k and IRAs are actually better protected than home equity.

I think so. In fact the IRS says that only about one in four taxpayers exceeds the standard deduction and gets any tax break for their mortgage interest. Then the majority of ones who can itemize only save pennies on the dollar, and still pay a lot of money out in after-tax mortgage interest.

And then again, there are the Bogleheads who know how to do math. I would wager far more than 1 in 4 bogleheads benefit from itemizing, and those that don't probably know so.

So ... you're saying that people who are affluent enough
... to be able to invest to the max in tax-advantaged retirement funds;
... and to have an adequate emergency fund;
... and have other debts paid off;
... and to have HSA, 529s and other higher priorities covered;

and still have enough money to spare that they need to decide whether to
.... invest more in bonds;
.... or to invest more in the market;
.... or to pay off the mortgage;

who are also both smart enough to do the math and affluent enough to be one of the 1 in 4 taxpayers who get a tax deduction for their mortgage

still may NOT be smart enough to realize that:
..., they should stop investing the freed-up mortgage payments,
..., or else should use some of their emergency funds;
..., or else should withdraw some of their investment funds;in order to pay the property taxes to avoid losing their home to tax foreclosure?

jimb_fromATL wrote:
A big problem is that paying down the mortgage is somewhat like buying a bond or CD that you cannot easily cash out before it matures. So IMO you need to have a lot of liquid assets before you pay extra on the mortgage. IMO, you should be maxing all available tax advantaged retirement accounts, have at least 6 months to a year of living expenses in liquid assets (including any Roth IRAs) and have most other debts paid off except perhaps student loans before you pay any extra on a mortgage.

This is why all my 'extra' money is going into my brokerage account. I want the liquidity until I'm ready to pay off the mortgage in full. I don't want to be in a position where I still owe $75k on a paid down aggressively mortgage, lost my job, and only have a 6 month emergency fund.

I feel I'm in a much better position with a 6 month emergency fund in cash, multiple years of living expenses in a brokerage, and a $200k mortgage. I'll also feel just as comfortable with a 6 month emergency fund in cash, no brokerage assets, and no mortgage. Until I have the option of paying off the mortgage in full I prefer the liquidity. I want to pick from one of those two scenarios, not something inbetween.

"Why settle for a 30 year mortgage when a lifelong mortgage would seemingly provide the same benefits? It should be an even better deal. What you haven’t mentioned is the decision to borrow money in the first place (indebtedness) is simply a decision – not a requirement. There are certainly ways to own a car, receive a high-level degree and even own a home without acquiring debt.

Prior to around 1940, the concept of a mortgage didn’t exist. You saved enough cash and/or built your own home. The idea of borrowing money for “basic” living expenses is a modern concept. Only a few decades later, most people have decided that borrowing to finance their lifestyle is both acceptable and necessary. I just saw an article saying the average new car financing is over $30,000 with a typical loan payoff of 68 months. That’s entirely due to marketing, not necessity.

My point is analyzing the benefits of financial arbitrage on big-ticket items entirely skips past the idea of simply buying them outright in the first place. Debt carries far more baggage than simply numbers in a spreadsheet."

I've never heard one of the 'hold the mortgage' folks advocate 40 or 50 year mortgages so as to maximize the expected gain for doing so. You don't see many advocating taking out a HELOC to put it in stocks either.

To the OP, if the effective rate one is paying on a mortgage is 4% and a bonds are yielding 2.5%, then it is mathematically superior to pay down the mortgage. I've brought up this issue before as well; it's not the total portfolio's returns that you should be comparing the mortgage to but the bonds you are buying. The need for liquidity makes this a subjective issue though.

“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Jags4186 wrote:I also would like to add that I hope when everyone figures out what their tax savings are from carrying a mortgage they are subtracting out the loss of standard deduction.

.

Only relevant if the mortgage is what is making it worthwhile to itemize. If state and local taxes, charitable donations, etc will get you to itemizing anyway, the paying off the mortgage will not change your tax strategy.

We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either |
--Swedroe |
We assume that markets are efficient, that prices are right |
--Fama

So ... you're saying that people who are affluent enough
... to be able to invest to the max in tax-advantaged retirement funds;
... and to have an adequate emergency fund;
... and have other debts paid off;
... and to have HSA, 529s and other higher priorities covered;

and still have enough money to spare that they need to decide whether to
.... invest more in bonds;
.... or to invest more in the market;
.... or to pay off the mortgage;

who are also both smart enough to do the math and affluent enough to be one of the 1 in 4 taxpayers who get a tax deduction for their mortgage

still may NOT be smart enough to realize that:
..., they should stop investing the freed-up mortgage payments,
..., or else should use some of their emergency funds;
..., or else should withdraw some of their investment funds;in order to pay the property taxes to avoid losing their home to tax foreclosure?

Go figure.

jimb

Obviously, I said no such thing, most of these things were not even mentioned in my post.

My point was that paying down or paying off a mortgage does not affect your current net worth, but affects your liquidity. Other funds may or may not be available to meet expenses, but even if they are, there can be additional taxes and penalties associated with withdrawals. There is no single optimal answer that is best for everyone. In many cases, keeping a low-interest mortgage with fully deductible interest may be more optimal than paying it off or paying it down.

jimb_fromATL wrote:
A big problem is that paying down the mortgage is somewhat like buying a bond or CD that you cannot easily cash out before it matures. So IMO you need to have a lot of liquid assets before you pay extra on the mortgage. IMO, you should be maxing all available tax advantaged retirement accounts, have at least 6 months to a year of living expenses in liquid assets (including any Roth IRAs) and have most other debts paid off except perhaps student loans before you pay any extra on a mortgage.

This is why all my 'extra' money is going into my brokerage account. I want the liquidity until I'm ready to pay off the mortgage in full. I don't want to be in a position where I still owe $75k on a paid down aggressively mortgage, lost my job, and only have a 6 month emergency fund.

Exactly, liquidity is an important issue. You never know what life has in store for you. During recessions, it can take more than 6 months to find another job. And of course that's assuming you are healthy and able to work again.

I feel I'm in a much better position with a 6 month emergency fund in cash, multiple years of living expenses in a brokerage, and a $200k mortgage. I'll also feel just as comfortable with a 6 month emergency fund in cash, no brokerage assets, and no mortgage. Until I have the option of paying off the mortgage in full I prefer the liquidity. I want to pick from one of those two scenarios, not something inbetween.

I personally feel much more comfortable with the first scenario than the second. Heck, I have $1.4 million in invested assets and about $320k mortgage at 3.375% 30 year fixed, and 2.21% after-tax, and I'm still not paying off that mortgage - though I'm paying it down faster over time to pay it in 15 years instead of 30. This has to do with tax optimization - as long as I'm working, I can deduct that mortgage interest and it's relatively cheap money. If I'm retired and in lower tax bracket, the interest deduction would not be so valuable anymore, and at that point I would prefer no mortgage at all.
Also, the majority of the $1.4 million is in tax advantaged accounts. If I paid off the mortgage, I would have limited liquidity outside of IRAs/401k (later would require quitting the job to access in significant amount).
So for me personally, I consider paying it off in full, not optimal, even though I can do so anytime.

Jags4186 wrote:I also would like to add that I hope when everyone figures out what their tax savings are from carrying a mortgage they are subtracting out the loss of standard deduction.

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Only relevant if the mortgage is what is making it worthwhile to itemize. If state and local taxes, charitable donations, etc will get you to itemizing anyway, the paying off the mortgage will not change your tax strategy.

Exactly - I would itemize no matter what from other deductions anyway- state taxes alone put me close, and property taxes way over. In all my years as a homeowner (20) all the interest has been 100% fully deductible and deducted.

People think about locking in a low rate for 30 years, but for a lot of people, it doesn't last nearly that long. I think the average home is owned about 7 years.

Some people have the privilege or the delusion of knowing more about their future than average, but I have neither.

I bought my current home in 2010 with a 4.625% 30yr mortgage. Refinanced in 2012 at 3.375% 30 yr fixed mortgage. Still have that mortgage 5 years later.
I'm paying it down sufficiently to pay it off in 2027, about 15 years from the refinance date, which is close to my expected retirement date - but if I haven't met my savings goal by then, I'll be able to contribute extra to 401k/IRAs due to being over 50 then and improved cash flow from mortgage payment being gone.
I owned my previous home for 13 years. Current one for 7. Yes, some of us do make very long term plans, even though life events can get in the way.

madbrain wrote:I personally feel much more comfortable with the first scenario than the second. Heck, I have $1.4 million in invested assets and about $320k mortgage at 3.375% 30 year fixed, and 2.21% after-tax, and I'm still not paying off that mortgage - though I'm paying it down faster over time to pay it in 15 years instead of 30. This has to do with tax optimization - as long as I'm working, I can deduct that mortgage interest and it's relatively cheap money.

At that rate, I wouldn't even make extra payments; your mortgage is below the market rate, so the money is really cheap. If you invest in long-term municipal bonds instead of mortgage payments, you come out ahead, and you reduce your risk, since the long-term municipal bonds have a lower duration than your mortgage. If rates fall, you can start making extra mortgage payments then, or refinance it to 15 years; if rates rise, you may be better off keeping the mortgage all the way to the end.

jimb_fromATL wrote:
Ironically, there have been polls that have shown that about 2/3 to 3/4 of taxpayers are opposed to eliminating the mortgage interest deduction, even though only 1/4 of them get any benefit from it at all. That's proof of how powerful the hype is from the mortgage/banking/housing industry.

Perhaps some of those surveyed own their home outright (or close to it), but recognize that the existence of the MID will help them eventually sell at a higher price.

Or perhaps some of those surveyed own their home outright (or close to it), but have children or friends currently benefiting from the MID.

Or perhaps some of those surveyed benefited from the MID in the past even though they no longer do, and feel that others deserve the same benefit going forward.

jimb_fromATL wrote:
Ironically, there have been polls that have shown that about 2/3 to 3/4 of taxpayers are opposed to eliminating the mortgage interest deduction, even though only 1/4 of them get any benefit from it at all. That's proof of how powerful the hype is from the mortgage/banking/housing industry.

Perhaps some of those surveyed own their home outright (or close to it), but recognize that the existence of the MID will help them eventually sell at a higher price.

Or perhaps some of those surveyed own their home outright (or close to it), but have children or friends currently benefiting from the MID.

Or perhaps some of those surveyed benefited from the MID in the past even though they no longer do, and feel that others deserve the same benefit going forward.

Or perhaps the survey had a bad sample.

Lots of other options there besides your conclusion.

I've been helping people with the math of mortgages and investments for several decades -- long before the advent of hand-held financial calculators, personal computers, spreadsheets, and the internet. I've also been helping folks on consumer and money talk forums for about 20 years.

In all that time, I've communicated with hundreds of people who also thought that the mortgage interest tax deduction was some kind of sacred cow that saved them a lot of money and should not be sacrificed -- and did not realize that they themselves were not benefitting from it much if any ... the way they had been led to believe. So in my opinion my own "surveys" also support that conclusion.

madbrain wrote:I personally feel much more comfortable with the first scenario than the second. Heck, I have $1.4 million in invested assets and about $320k mortgage at 3.375% 30 year fixed, and 2.21% after-tax, and I'm still not paying off that mortgage - though I'm paying it down faster over time to pay it in 15 years instead of 30. This has to do with tax optimization - as long as I'm working, I can deduct that mortgage interest and it's relatively cheap money.

At that rate, I wouldn't even make extra payments; your mortgage is below the market rate, so the money is really cheap. If you invest in long-term municipal bonds instead of mortgage payments, you come out ahead, and you reduce your risk, since the long-term municipal bonds have a lower duration than your mortgage. If rates fall, you can start making extra mortgage payments then, or refinance it to 15 years; if rates rise, you may be better off keeping the mortgage all the way to the end.

There is always the - maybe very small - risk of bond default - whereas the mortgage company certainly isn't going to forget about my loan until it's paid off.
Refinancing the mortgage later on is not necessarily on the table if I'm no longer working with sufficient income to get a loan, or no longer able to work. I don't want to rely on that.
I think it's more likely rates will rise. I know my mortgage is currently below market. I just don't consider the muni bond to be equivalent risk, or lower risk.
Muni bond interest would also count against MAGI for purpose of Obamacare subsidy in retirement, and that could be very costly if they put me just over the cliff for subsidies. Of course, I can't really know if the law will still be the same in 10-15 years - I would like to see that steep income cliff eliminated, but as of today, it's still on the books.
In that situation, if rates have risen, I might have depreciated muni bonds, and would be forced to realize a loss by selling the muni bonds to pay off the mortgage and keep below MAGI income. In the worst case, the bonds might not even cover the mortgage balance due to depreciation.
I think it's fair to say there are other income cliffs in the tax code, but this one is probably the worst one I'm aware of at this time, and healthcare costs will be of utmost importance to us.

Interesting thread. I was always curious about this so I took some time to run my numbers in a calculator.
mortgage amount 735k/30 years @ 3.625. Fed tax bracket: 33% and State: 6.4%. My rate after tax is 2.273%.
So, instead of paying down the principal and I put my money in a National High Yield Muni bond fund (VWAHX) I can get close to 2.92 (SEC yield) and taxable equivelent yield would close to 4%! So I am getting 1.727% for keeping my mortgage?

I think I would do something like this because of liquidity and relative saftey of the muni bond market. I know its not risk free. Ofcourse it maybe better to put the extra money in total stock market and once you have enough money equivilent to outstanding balance of the mortage you sell it and pay the thing off.

keith6014 wrote:Interesting thread. I was always curious about this so I took some time to run my numbers in a calculator.
mortgage amount 735k/30 years @ 3.625. Fed tax bracket: 33% and State: 6.4%. My rate after tax is 2.273%.
So, instead of paying down the principal and I put my money in a National High Yield Muni bond fund (VWAHX) I can get close to 2.92 (SEC yield) and taxable equivelent yield would close to 4%! So I am getting 1.727% for keeping my mortgage?

You counted the taxes twice; you should compare the after-tax rate on the mortgage to the after-tax rate on the bond fund. In your situation, that is 2.43% after federal tax on the mortgage, and 3.02% on the muni fund (Admiral shares); both funds will be subject to state tax, so I ignored the state tax.

And High-Yield Tax-Exempt is not the best fund for comparison, because of the credit risk. Long-Term Tax-Exempt, at 2.48% on Admiral shares, is a better comparison. This is close to break-even, but it's still a good deal because the muni fund has a shorter duration (7 years) than your mortgage prepayment. (You might still choose to hold High-Yield Tax-Exempt, but this is a choice to increase your risk for higher returns, not a free lunch. Also, don't use High-Yield Tax-Exempt if you owe AMT.)

Boy, with everyone getting such cheap leverage and mortgages being such a bad deal for the lender, makes you wonder who these dumb dumb lenders are. Oh wait, I think it's largely you and me via our total bond market funds.

I think as someone said, it largely comes down to personal circumstances. I personally left my details out originally to have a broader discussion. But my bias is towards paying down the mortgage for folks with high incomes and high savings rates; especially if one has a good sized portfolio already. When you have a big lead and the clock is ticking down, you don't need to try to arb out extra basis points to win the game...

I also agree with Money Mustache in that all too many people play the "gotta keep it for the write off" game but then don't fully save/invest to the extent they might otherwise. A larger mortgage becomes something that just enables larger near term expenditures.

keith6014 wrote:Interesting thread. I was always curious about this so I took some time to run my numbers in a calculator.
mortgage amount 735k/30 years @ 3.625. Fed tax bracket: 33% and State: 6.4%. My rate after tax is 2.273%.
So, instead of paying down the principal and I put my money in a National High Yield Muni bond fund (VWAHX) I can get close to 2.92 (SEC yield) and taxable equivelent yield would close to 4%! So I am getting 1.727% for keeping my mortgage?

You counted the taxes twice; you should compare the after-tax rate on the mortgage to the after-tax rate on the bond fund. In your situation, that is 2.43% after federal tax on the mortgage, and 3.02% on the muni fund (Admiral shares); both funds will be subject to state tax, so I ignored the state tax.

And High-Yield Tax-Exempt is not the best fund for comparison, because of the credit risk. Long-Term Tax-Exempt, at 2.48% on Admiral shares, is a better comparison. This is close to break-even, but it's still a good deal because the muni fund has a shorter duration (7 years) than your mortgage prepayment. (You might still choose to hold High-Yield Tax-Exempt, but this is a choice to increase your risk for higher returns, not a free lunch. Also, don't use High-Yield Tax-Exempt if you owe AMT.)

Are you referred to VTEAX? I think for higher returns and risk I may go with a CEF offered by pimco. I think others have said they would rather use S&P index which is also a good idea.

I have risk tolerance; i feel "bad" not paying down the principal because that has always been programmed into me.

Jags4186 wrote: If the economy tanks and I lose my job, I can sell assets. You can't eat your paid off mortgage (and a HELOC may not be available in this setting).

I take the opposite view--having the mortgage paid off greatly lowers my immediate need for cash and also provides a greater buffer against a financial crisis such as job loss. It also lowers my future liabilities and thus I can afford the risk of investing more aggressively with less danger of being forced to sell investments before my desired time frame.

As suggested in this blog post on personal risk by Of Dollars and Data blog, "Ability to Take Risk = Assets - Liabilities + Time"

I aggressively paid off my mortgage over the course of several years ending in 2013. Mathematically, I would have done "better" by putting it all in the market, but that is known only in hindsight. The peace of mind and sense of security I have now is worth far more than the few extra thousands I might have earned while still having a huge debt hanging over my head. of course, removing that monthly payment greatly increased the amount I've been able to save since then (buying a second house in cash along the way.)

Like WarChest said, I am not sure there is a right or wrong way to do it. It is largely a personal decision on risk and your own time horizon (as well as the mortgage horizon), so everyone will see it differently.

Boy, with everyone getting such cheap leverage and mortgages being such a bad deal for the lender, makes you wonder who these dumb dumb lenders are. Oh wait, I think it's largely you and me via our total bond market funds.

I think as someone said, it largely comes down to personal circumstances. I personally left my details out originally to have a broader discussion. But my bias is towards paying down the mortgage for folks with high incomes and high savings rates; especially if one has a good sized portfolio already. When you have a big lead and the clock is ticking down, you don't need to try to arb out extra basis points to win the game...

I also agree with Money Mustache in that all too many people play the "gotta keep it for the write off" game but then don't fully save/invest to the extent they might otherwise. A larger mortgage becomes something that just enables larger near term expenditures.

I'm with you on paying off the mortgage. I was pretty much 100% stocks until most of the mortgage was paid off. I then refinanced with a 5/30 loan and accelerated the payoff while I started buying bond funds. The interest on mortgage was around 2.5%, which was similar to the bond return. It probably didn't make much of a difference, but seemed more beneficial from a cash flow standpoint, but that might just have been in my head.

Jags4186 wrote:I also would like to add that I hope when everyone figures out what their tax savings are from carrying a mortgage they are subtracting out the loss of standard deduction.

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Only relevant if the mortgage is what is making it worthwhile to itemize. If state and local taxes, charitable donations, etc will get you to itemizing anyway, the paying off the mortgage will not change your tax strategy.

Exactly - I would itemize no matter what from other deductions anyway- state taxes alone put me close, and property taxes way over. In all my years as a homeowner (20) all the interest has been 100% fully deductible and deducted.

Exactly. What state one lives in matters a lot. Like you, state income taxes alone put me at just under the standard deduction and when I throw in property taxes I'm way over. Mortgage interest has always been 100% deductible for me. If one lives in a high tax state and owns a home, it doesn't take a lot to get over the standard deduction before you factor in mortgage interest.

Jags4186 wrote:I also would like to add that I hope when everyone figures out what their tax savings are from carrying a mortgage they are subtracting out the loss of standard deduction.

.

Only relevant if the mortgage is what is making it worthwhile to itemize. If state and local taxes, charitable donations, etc will get you to itemizing anyway, the paying off the mortgage will not change your tax strategy.

Exactly - I would itemize no matter what from other deductions anyway- state taxes alone put me close, and property taxes way over. In all my years as a homeowner (20) all the interest has been 100% fully deductible and deducted.

Exactly. What state one lives in matters a lot. Like you, state income taxes alone put me at just under the standard deduction and when I throw in property taxes I'm way over. Mortgage interest has always been 100% deductible for me. If one lives in a high tax state and owns a home, it doesn't take a lot to get over the standard deduction before you factor in mortgage interest.

Agree though one thing I always wonder about is AMT. I always get hit with it and pay a lot. Household AGI north of $600k in Cali, property taxes, mortgage interest will do that to you pretty much no matter what. And that is with paying minimal mortgage interest. So if I wasn't paying down the mortgage and had a ton of mortgage interest write off wouldn't I get hit with more AMT anyways, essentially negating a lot of the "tax break" of having a mortgage?

Let's for argument's sake assume that the expected return of stocks is 8% (that's probably on the high side) and the expected return of cash in a cookie jar is 0% (hard to argue with that). With a 50/50 stock/cash asset allocation, the expected return of the portfolio is 4%. With your logic, then one should keep one's 3.5% mortgage in order to invest more according to one's asset allocation, because the expected return of the stock/portfolio is higher than that of the mortgage.

Let's for argument's sake assume that the expected return of stocks is 8% (that's probably on the high side) and the expected return of cash in a cookie jar is 0% (hard to argue with that). With a 50/50 stock/cash asset allocation, the expected return of the portfolio is 4%. With your logic, then one should keep one's 3.5% mortgage in order to invest more according to one's asset allocation, because the expected return of the stock/portfolio is higher than that of the mortgage.

I don't buy that.

selters,

Why?

Instead of paying $800 extra into the mortgage, the person invests $800 extra into his 50/50 portfolio. In that case, that person should use his total portfolio return as a comparison.

Yes, the risk is different.

In the case of the mortgage, you have a liquidity risk. In the case of the portfolio, you have a return risk. It is not a straight apple to apple comparison.